A more liberal ODI policy

A more open economy? The Decision s impact on China s ODI and FDI activities Authors: Peter Fung Global Chair KPMG Global China Practice Email: peter.fung@kpmg.com Tel: +86 10 8508 7017 Peng Yali Head of Research KPMG Global China Practice Email: yali.peng@kpmg.com Tel: +86 10 8508 5828 According to the The Decisions by the Central Committee of the Communist Party of China on Some Major Issues Related to Comprehensively Deepening Reform (hereafter refered to as the Decision ) passed in the Third Plenum of the 18 th Central Committee, outbound direct investment (ODI) and foreign direct investment (FDI) both received relatively less coverage than other, more profound issues. However, the policy tone toward continued support of ODI and FDI is firm and positive, and speeches given by high officials after the release of the Decision indicate that siginificant policy measures would be adopted. These signals and measures, if adequately implemented, would have a positive effect on ODI and FDI. Encouraging ODI activities amongst Chinese enterprises A more liberal ODI policy First, the Decision stresses that China should let enterprises (instead of government agencies) and private individual investors (instead of State-owned enterprises) play a more significant role in ODI activities. This means that the Chinese government will give more authority to enterprises interested in expanding internationally. In doing so, the government will overhaul the complex application requirements and simplify the approval processes. In the future, enterprises may only need to file their overseas projects with relevant authorities, rather than seek approval from them. Meanwhile, the Decision states that the government will provide better service and guidance to enterprises that decide to enter the global market. Overseas investment by companies and individual investors will be increased. Companies and individual investors will be allowed to play a principal role in overseas investment. They will be encouraged to engage in overseas investment and cooperate by leveraging their own competitive advantages. I --- The Decision 1

In the past, government intervention posed significant challenges to Chinese companies that wanted to invest overseas. As these companies competed for projects in foreign countries, some processes took several months to obtain government approval. Under these circumstances, some Chinese firms had to forfeit investment opportunities to competitors. Situations were more adverse for small- and medium-sized privately-owned companies, which had limited resources to deal with government bureaucracy and ongoing approval delays. The Decision initiated a major move to reduce government intervention; it will enable Chinese companies to have the final say in their overseas investments and make decisions in a timely manner, unless the projects: affect national security, compromise the safety of the ecological environment, exploit strategic resources, or disrupt other key public interests. Secondly, the Decision also specifies many fields in which the government openly encourages overseas investment. This includes granting companies the freedom to engage in infrastructure projects and sign labor supply contracts at their own risk, and allowing investors to use innovative ways to engage in green-field, M&A, security and joint investment, etc. The policy will widen the scope of China s overseas investment and create more opportunities for institutions and individuals. Going out as a means of transformation In The Dream Goes On: Rethinking China s Globalization, a unique research report that KPMG released in 2013, we point out that the next decade is a critical period for China s economic restructuring. Chinese companies continuous progress toward innovation and competitiveness will be substantial during this transformation period. But to make progress, China s enterprises must make the most efficient use of global resources in overseas markets. The Decision has sent a straightforward message that China is determined to clear the way for its enterprises to go out, 2

so that they could be in a better position to compete on a global stage. ODI has become an important driver for China s economic development in recent years. China is in the midst of a structural shift, from a country that has historically been a recipient of inbound investment, to a country that is now investing significant funds around the world. With the new reform plan, it can be expected that a greater number of Chinese companies will invest in diversified markets, and operate globally. In addition, the market capitalization of Chinese companies continues to increase. This will undoubtedly influence the willingness and ability of large Chinese companies to invest globally. As seen below, in 2013, 85 companies headquartered in mainland China made the Fortune Global 500 list, up from only two in 1996. This trend is likely to continue in the next few years. Figure 1 Chinese Global Fortune 500 Companies 90 80 70 60 50 40 30 20 10 0 85 69 57 42 34 19 22 25 2 3 3 6 9 11 11 11 14 15 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Fortune Chinese website. http://www.fortunechina.com/fortune500/c/2013-07/08/2013g500.htm Opportunities for both SOEs and POEs State-owned enterprises (SOEs) seem to be a major beneficiary of measures specified in the Decision, as they are still the primary contributors of global investments. They have enjoyed competitive advantages in terms of: access to capital, government protection, and de facto monopoly position in many industries. With simplified application formalities and less administrative restrictions, SOEs can take full advantage of their position, and speed-up the pace of their global investment. However, less government scrutiny might lead to poor investment decisions, which could have serious ramifications pertaining to China s financial stability. Thus, the government may still need to impose some executive control on SOEs. The reduction in government interference is also good news for privately-owned enterprises (POEs), which are playing an increasingly important role in Chinese outbound investment. POEs enjoy certain advantages when it comes to investing overseas; their ownership structures are usually clear and effective, and fast and flexible decision-making processes help them quickly adapt to 3

the volatile global market. Nevertheless, POEs only account for a small portion of China s total ODI. Most of them have little government support and are often held back by long approval procedures. The Decision aims to bridge the gap between SOEs and POEs by building a favorable and fair regulatory environment. This will lead to more overseas investment by private companies, especially those of small- and medium-size. Currently, SOEs are the primary entities involved in China s global exploration of resources. The new measures will enable POEs to receive equal treatment. This will encourage POEs to be more aggressive with global opportunities. SOEs are still in an advantageous position, with better access to government support and state foreign exchange reserves. Moving up the value chain In terms of production and sales volume, China is a manufacturing giant. However, from a professional perspective, a majority of Chinese companies are still located at the relatively low-end of the world value chain. The 12th Five-Year Plan (2011-2015) promotes internationalization as an important part of China s industrial development. The Decision has reassured this strategy and promised more support and guidance. In a speech after the Third Plenum by Mr. Gao Hucheng, the Minister of Commerce, he encouraged Chinese companies to go overseas and set up research and development facilities, learn from advanced production practices, establish marketing and sales networks, develop their own brands, and improve their international competitiveness. For example, China s local auto brands, which face fierce competition from international brands and suffer from overcapacity in the domestic market, have already started overseas operations as part of an effort to expand into new development areas. In the initial period, most of them just built assembly plants in foreign countries. After reaching a certain stage of development, they 4

realized that they needed to enhance their capabilities in all aspects including branding, marketing, R&D, management skills, etc., which could be achieved through overseas M&A. Thus, Chinese auto makers may launch more overseas M&A in the future, as the reform promised by the Decision will allow them more flexibility and less uncertainty to bid for foreign assets. Another probable beneficiary is the high-end equipment manufacturing industry, named as one of the seven strategic emerging industries in China s 12th Five-Year Plan. The Chinese manufacturing industry urgently needs to restructure so that it can move toward the high-end of the industrial chain. Going out to utilize international market resources is an effective way to achieve this goal. Many companies have ventured overseas to obtain advanced technological know-how, and other capabilities through corporate acquisitions. Quick market response and centralized decision-making processes are vital for the success of such transactions. Encouraging FDI activities into China Lowering entry barriers The Decision suggests further reforms are aimed at building a new market access and administrative system - a system that will be more efficient, transparent, and equitable. This is an effort to open more significant channels to the outside world and generate more FDI. Foreign investors will be given pre-established national treatment, and will be subject to, and evaluated with a 'negative list approach, when applying for inbound investment in China. The government will deal with foreign and domestic investors equally in the admission and establishment stages of their investment projects. The process of project application, assessment and approval will be streamlined, with relevant regulations and laws amended accordingly. A negative list will clarify which areas of the economy foreign companies are prohibited from accessing. It will replace the current investment guidelines that only indicated the industries in which foreign firms were allowed to invest. A unified market access system based on a negative list approach will be established. Various market players can by law have equal access to sectors that are not on the list. Foreign investors will be given pre-established national treatment and will be subject to the 'negative list approach. --- The Decision 5

The Decision shows that China, the largest receiver of FDI among developing countries in the world, still considers FDI a major engine for economic growth, and strives to improve the regulatory environment for foreign firms investing in China. The newly proposed methods of administration aim to address some of key concerns of foreign investors, and boost their confidence in the Chinese market. Industry opportunities In addition to the administrative model change, the Decision specifies that China will open up more domestic industries to foreign investment, which include: finance, education, culture, health care, architectural design, nursery care and care services for the elderly, accounting and auditing, commerce and trade, logistics, and e-commerce. The country will also allow wider market access to the general manufacturing sector, including: steel, chemical, and automotive industries. These measures for opening up are in line with China s 12th Five-Year Plan, which calls for the reform of the financial sector, industrial restructuring, and the development of service industries. Tremendous potential still exists for foreign companies to participate and compete in China. Figure 2 displays the market share of foreign companies versus Chinese companies in selected industries in China. The data shows that MNCs span a wide range of industries. In some industries (e.g. communication & electronic equipment and automobile), foreign companies have gained dominant positions, in some they compete with domestic companies fairly well, and in others (e.g. commercial banking and life insurance) their presence is minimal. For companies that have deeply penetrated the market and established a competitive footing, the mission is to continue to expand their operations, gain a more firm position in the market, and create synergies between international and Chinese businesses. For companies that have not made satisfactory progress, there is still a very broad market to be 6

tapped. Future success is contingent on working through the complicated business landscape and, to some extent, the further opening up of some industries to foreign competition. The introduction of foreign competition to the financial industry marks an important step for some long-awaited reforms in the sector, where state-owned financial institutions and their monopoly power have led to low efficiency and an accumulation of risks. As shown in Figure 2, foreign banks only had a small presence in China in 2012. It is predicted that after these reforms are implemented, the industrial landscape may change rapidly. Foreign banks may get the green light to further expand into financial service domains that were previously forbidden, and provide products and services at rates determined by the market. In addition, foreign companies may be permitted to sell shares in China to raise capital, which would be considered a significant boost to the China s capital market. One obvious benefit of opening up the financial sector is that reform needs innovation, where foreign banks have capabilities and experience. Figure 2 Market Share of Selected Industries: Foreign vs. Chinese 2012 Share of foreign funded enterprises Share of domestic funded enterprises 0% 20% 40% 60% 80% 100% Communication & Electronic Equipment Automobile Personal Care Product Television Dietary Supplement Apparel Food Beverage Electrical Machinery and Equipment Paper & Paper Product Raw Chemical Material & Chemical Product Pharmaceuticals Refrigerator Life Insurance Commercial Banking 44.50% 43.35% 40.00% 35.44% 33.28% 30.40% 29.97% 28.34% 25.97% 24.52% 20.60% 3.81% 1.93% 68.20% 75.69% 24.31% 31.80% 55.50% 56.65% 60.00% 64.56% 66.72% 69.60% 70.03% 71.66% 74.03% 75.48% 79.40% 96.19% 98.07% Sources: National Bureau of Statistics of China: http://www.stats.gov.cn/tjsj/ndsj/2012/indexch.htm; China Association of Automobile Manufacturers: http://www.caam.org.cn/; Nielsen: http://cn.nielsen.com/site/index.shtml. In the manufacturing sector, the Decision states that the Chinese government will lower market entry requirements for foreign investors, in terms of: registered capital, ownership structure, and 7

business scope. Moreover, it encourages them to move their China operations to the higher-end of the value chain. It can be expected that foreign companies may start or expand their business in China with less difficulty in the future, and they may invest more in high-value projects, such as establishing regional headquarters, R&D agencies and distribution centers. The Decision advocates that China s economy should depend more on consumption than on investment. The opening up of the service sector to foreign investment will help realize this objective. Service companies from developed countries, which have relatively more advanced service features will likely initiate first-mover positions in such industries that are open to competition. This will create new development opportunities for the business, additional jobs for local residents, and contribute to the improved living standards amongst Chinese people. Investment entry barriers will be relaxed, and domestic and foreign investment laws and regulations will be unified. Policies on foreign investment should be stable, transparent and predictable. --- The Decision Free trade zones The Decision stresses the importance of the recently established Shanghai Free Trade Zone, and its importance toward further reform and opening up measures. It also says that more free trade parks (ports) will be established following the Shanghai pilot project. In addition, China will open more border areas to foreign investors, as it tries to improve infrastructure and transportations for these areas, which might offer good opportunities for development. A few free trade zones for border regions have been established, such as the Silk Road Economic Zone and the China-ASEAN Free Trade Area, which will enable the border areas with Southeast Asia, Northeast Asia and Central Asia to become new growth points for foreign investment in China. Immediately after the closing of the Third Plenum, on December 2nd, the People s Bank of China (PBOC) issued a directive in support of the Shanghai Free Trade Zone. Many measures are designed to facilitate cross-border investment. For example, companies investing cross-border can directly conduct payment settlement and currency exchange through banks without going through the preapproval process. At the same time, the document lists procedures to further open the financial service sector to foreign capital. Foreign investors can engage in security and future investment, and their overseas parent companies can issue RMB bond in China. Mr. Zhang Xin, the director of PBOC s Shanghai Branch, summarizes three key points of this policy directive. 1) Companies can conduct business with banks directly without 8

preapproval; 2) Multiple entities can engage in cross-border financing and investment, including corporations, non-banking financial institutions, individual business people, etc.; 3) Cross-border financing will be more convenient; companies can raise RMB or foreign currency denominated capital from overseas markets. Looking to the future Some of the measures specified by the Decision are expected to have a positive impact on both ODI and FDI. For example, the optimization of formation mechanism of the RMB exchange rate and the acceleration of Renminbi capital account convertibility will promote bilateral investment opportunities by allowing cross-border flows of capital to operate more freely. Eventually, these measures will lead to the full and free convertibility of the RMB, and will drive RMB internationalization as well. This may further encourage investment activities between China and the rest of the world. The Decision also indicates that China will expedite negotiations on investment treaties with relevant countries and regions, and promote the establishment of free trade zones. Such arrangements will remove investment barriers and offer greater protection for enterprises of contracting parties, with the overall goal of fostering investment amongst these countries. China has already signed these types of agreements with a number of countries. Currently, China is negotiating with the European Union to enact a landmark bilateral investment treaty. The success of such a treaty is widely expected to help China upgrade its economic infrastructure, and better integrate with the global economy. By reading the stated policy directions and measures of the Decision, it can be reasonably concluded that the foundations of China s economic policy of the past over 30 years of reform and opening-up have remained unchanged and been reinforced by the Third Plenum. Some of the declared measures, for example, the 9

orderly further opening up of the financial services, education, cultural activities, healthcare, and the elimination of entry barriers to nursery, elderly care, architect design, auditing, logistics and e-commerce, will generate real benefits upon implementation. Thus, implementation is the key to further organic growth within China, and how it is structured in the near-term is worth closer attention. Based on the principles we have seen from the Decision, we have reason to believe that ODI and FDI will experience favorable development as a result of this initiative. About KPMG s Global China Practice (GCP) KPMG s Global China Practice (GCP) was established in September 2010 to assist Chinese businesses that plan to go global, and multinational companies that aim to enter or expand into the China market. The GCP team in Beijing comprises senior management and staff members responsible for business development, market services, and research and insights on foreign investment issues. There are currently over 50 China Practices in key investment locations around the world, from Canada to Cambodia and from Poland to Peru. These China Practices comprise locally based Chinese-speakers and other professionals with strong cross-border China investment experience. They are familiar with Chinese and local culture and business practices, allowing them to effectively communicate between member firms Chinese clients and local businesses and government agencies. The China Practices also assist investors with China entry and expansion plans, and on both inbound and outbound China investments provide assistance on matters across the investment life cycle, including market entry strategy, location studies, investment holding structuring, tax planning and compliance, supply chain management, M&A advisory and post-deal integration. kpmg.com/cn The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. International 10 have any such authority to obligate or bind any such authority to obligate or bind any member firm. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.